In this listener requested episode, we look at the difference between Dividend Reinvestment Plans (DRPs) and Dividend Substitution Share Plans (DSSPs). There are some very important benefits to each plan that may mean one plan will suit investors better than the other.

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You’re able to find the transcript of the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. Mark, you’ve had a really big week this week. A momentous week.

Mark LaMonica: A momentous, momentous is probably a bit much.

Jayamanne: You’ve been playing squash for a very long time now.

LaMonica: I mean, at least been a little while. But I started this, I started this, and I’ve talked about it in the podcast before. I started this tournament.

Jayamanne: Yes.

LaMonica: The Autumn Pennant.

Jayamanne: There you go. Couldn’t come up with another name?

LaMonica: Well, I joined it. I did not name it.

Jayamanne: Mark’s won two matches.

LaMonica: I’ve won three matches in a row, Shani. Thank you for after losing my first five matches. I have now won three in a row.

Jayamanne: It’s very impressive.

LaMonica: And you went there briefly during your university tour. We were playing the University of Sydney, and I was playing some guy in uni. And as you tell people, I’m ancient.

Jayamanne: And I have never said that before, Mark.

LaMonica: The university, you said it five minutes before we were recording this. The University of Sydney is the number one team. Nobody on their team had lost a match yet. And then I beat this little uni student.

Jayamanne: This little uni student.

LaMonica: He was little. He’s probably not listening to this.

Jayamanne: Very respectful. Good sign of sportsmanship. But what are we talking about today, Mark?

LaMonica: We’re going to turn to our old friend, the dividend today, Shani.

Jayamanne: You must be pumped.

LaMonica: I am. I’m very excited. But everyone loves a dividend, Shani. Even you like dividends. It may not be your primary focus, but you’re probably not complaining when it gets to your account, right? So we’re going to talk about dividend reinvestment. And this was a question that somebody sent in. We’re going to talk about a dividend reinvestment plan or DRP. There’s going to be lots of acronyms. Well, two main ones that we’ll talk about a lot. And a dividend substitution share plan or DSSP.

Jayamanne: And before getting into specifics, we want to talk about some theory. And we’ve mentioned this before on the podcast, but most of the returns that you see are total returns. And a total return assumes that dividends are reinvested.

LaMonica: And that simply means that if you go and look at the return on an ETF, the only way you’re getting that publicized return is if you reinvest those distributions back into the ETF. Same thing with indexes in general. So just something to be aware of.

Jayamanne: And that seems like a good reason to reinvest your dividends. What are some reasons to not reinvest dividends?

LaMonica: Well, the obvious one is, of course, if you’re spending the money. So you don’t want to reinvest it if you’re using that dividend income to fund something. But for the non-dividend spenders, there are these two different camps with dividend reinvestment. The first camp is people who collect those dividends, and then they just choose where to invest them. So this is just more cash to invest, which might be mixed with other cash that goes in your account, so other contributions you are making it in there. Then you allocate it wherever you see fit. The second camp are the people that automatically reinvest income in whatever, share, fund, or ETF paid that income.

Jayamanne: So it is important to think about the implications of each move. If you choose where to invest income, you are relying on your skill as an allocator of your own capital. If you’re reinvesting dividends, you are saying that you may not make the best decisions at choosing the timing and where to reinvest that income, and you’re just automating it.

LaMonica: So just something to think about. I think our message is always that there are many ways to be a successful investor, but you should understand what you’re doing. And we’ll repeat this a little bit at the end of this episode as well. So there are implications of the different actions you take, and there are different drivers of success and failure in anything that you do.

Jayamanne: And this gets us into the specifics of the two different approaches. We’ll start with a dividend reinvestment plan. In Australia, you sign up for a dividend reinvestment plan through your share registry.

LaMonica: And mechanically, the way that this works is that when the dividend is paid, instead of cash, you get shares or fractions of shares. Typically, there’s no transaction cost for this, and slowly over time, your position just builds up as each dividend gets paid and you get more shares.

Jayamanne: And we’ve spoken about this before, but there are a couple of things that you do get from this. The first is that it is a form of dollar cost averaging. You’re acquiring more shares at different levels as the price fluctuates.

LaMonica: And you are also getting more shares, which means that your total passive income will increase if that dividend is maintained. That means you’re getting even more shares, and that, of course, is compounding, that’s your passive income compounding over time.

Jayamanne: One of the big downsides is that you still owe taxes on those dividends. So even though you never get the cash when tax time comes, you will have to pay your marginal tax rate on any of that income that you’ve received. That means planning for that each year, which most likely means saving additional money or keeping it available to pay taxes.

LaMonica: There is one way to get around this. In many cases, you can do a partial dividend reinvestment plan. So you can estimate your tax liability, or you can just pick a random percentage, but you can estimate your tax liability and then take that portion in cash and reinvest the rest. You then just save that cash until tax time comes. And this does sound like something you would like, Shani.

Jayamanne: I do something very similar, because I don’t like to have a huge tax bill at tax time. But I do try and work out what I’ll owe and I make sure that I’m covered.

LaMonica: Tax time is always good because it’s October 31st, like six o’clock at night, and I’m furiously messaging Shani saying, what does any of this stuff mean?

Jayamanne: For some reason, we’re always hanging out on October 31st. Like the last few years, you’ve always been in a panic.

LaMonica: I know. We’ve always hung out and gone out for drinks. And then it’s like me…

Jayamanne: …trying to figure it out.

LaMonica: Trying to figure it out. So it’s nice. It’s a tradition of ours to drink on tax day. Shani does her taxes the minute she can. So it is very different. She’s always very, very prepared with everything.

Jayamanne: But that is the dividend reinvestment plan. What’s next?

LaMonica: Okay. We’ll contrast this with a dividend substitution share plan. In this case, you do not have to pay taxes as the income is generated, but instead you defer the tax until you sell the shares.

Jayamanne: And to start with an important caveat, a dividend substitution share plan and everything we’re describing is for Australian resident tax payers.

LaMonica: Exactly. So, a dividend substitution share plan can apply in a couple situations. Many listed investment companies, LICs, have dividend DSSP plans to make this a little bit easier. And it can happen for shares, but it generally occurs if you’re getting bonus shares.

Jayamanne: And a bonus share typically is a way to reward shareholders by issuing additional shares. But the application to a LIC is probably better to explore. So, Mark, who would want to use a DSSP?

LaMonica: Well, since you’re deferring taxes, the people that this makes the most sense for is those that are in the highest tax brackets. If you were in the top tax bracket and think that you could potentially sell the shares in the future when you might be in a lower tax bracket, that may make sense.

Jayamanne: The issue, of course, is that you don’t know the price of the share in the future when you do sell it. But that, of course, is always a risk and you have the same risk for the dividend reinvestment plan.

LaMonica: But there is one enormous caveat. For a DSSP, there are no franking credits.

Jayamanne: Now, in some cases, this would be applicable and some it wouldn’t. Franking credits are, of course, not available to non-Aussie shares or for other types of securities like bonds. Franking credits are also not available for REITs. But let’s assume you are considering forgoing franking credits. We can go through the maths of how this would work.

LaMonica: Okay, here’s our example. Assuming a company has a fully franked dividend of $1 and it’s in the 30% company tax bracket, which most companies in Australia are in. The franking credit would be worth $0.43. You’re entitled to that if you reinvest the dividends. Now, if you sign up for a dividend substitution share plan, that would go away. You’re the tax expert, as we just talked about.

Jayamanne: We’re not allowed to use the term expert at Morningstar. You’re going to get in trouble for more from our compliance department.

LaMonica: What’s new? You’re a person somewhat familiar with taxes.

Jayamanne: I’ll take that. So the franking credits can offset a tax liability or if they exceed it, you will get your money back. The tax liability in this case on that $1 dividend will be based on your marginal tax rate. If you’re in the 45% marginal tax rate, you will still owe tax on that dividend, but very little at $0.02 on the dollar dividend. At every other marginal tax rate, the franking credit would exceed the taxes due on the dividend.

LaMonica: Now, not every share is fully franked, obviously. We used a fully franked example there. So that is a consideration, but in Australia, for Australian companies, you can offset a good deal of the downside of reinvesting that dividend, which is saving extra money for taxes.

Jayamanne: The other question, of course, is should you do it or collect the money and invest it when and in what you think represents the best opportunity? We often talk about the challenges investors face when they’re trying to pick investments and how the timing decisions of those investments can go wrong.

LaMonica: And we’re going to have to talk about the mind the gap study. I feel like my entire life…

Jayamanne: …is talking about this study.

LaMonica: Talking about the mind the gap study. I should win some sort of award for like biggest cheerleader for the mind gap study. I like it. We talk about it a lot of times, the difference between or how poor timing decisions impact investor returns the latest one 1.10% a year. So investors hurt themselves by making poor timing decisions by 1.1% a year. So that’s of course the problem. If you’re in there trying to figure out you’re collecting those dividends and cash and trying to allocate it, you may make a poor decision. But ultimately, probably if you’re holding individual shares or you’re going out and building a portfolio with ETFs, you are doing this anyway. So just remember active decisions can be a bit of a problem. But if you’re already committed to that strategy, I guess what’s the difference, right?

Jayamanne: So Mark, tell me about you. You love dividends?

LaMonica: Not just me in general.

Jayamanne: What do you do?

LaMonica: When I first started investing, I was a pure dividend reinvestment guy. So I was trying to grow my passive income as I talk about and as we talked about in all these episodes, I really like yield at cost as a measure. So that’s a metric that I used to judge the performance of my overall portfolio and individual investments. Now, that’s not how taxes work. I’m very carefully say that. But I always reduce my cost basis by that dividend reinvestment, just because it gives me a metric that I can use to judge success.

Jayamanne: So you say that you do this in the past. So what do you do now?

LaMonica: Well, I do spend some of the money. So I said that. So obviously, I’m not reinvesting the dividends on all sorts of stuff, Shani. Not really like flights. Large hotel bills. But I still do this with my other positions and in accounts where I don’t do it. But I don’t really feel, I guess, as strongly as I did before. And so I don’t really, I don’t have an issue with just collecting dividends. You know, I think ultimately, it automates part of the investing process. It’s one less thing to worry about. So that’s why I leave the dividend reinvestment on. But yeah, that’s just me. So I’m still contributing these accounts. So I’m still picking what to invest in with that money.

Jayamanne: So let’s sum this up. A DSSP might be worth it if you’re in the highest tax bracket. But you also need to consider the fact that you won’t be getting franking credits.

LaMonica: And a DRP can be a great way to automate the reinvestment of your dividends. This is a way that you can compound your passive income and your position value. And remember, the returns that are generally published for markets or funds or ETFs include dividend reinvestment. So if you don’t do it, your return on that position will be lower than what’s generally published.

Jayamanne: But by not doing it, you could potentially allocate it to more attractive opportunities. But of course, many investors do struggle with that timing of when to purchase and sell investments.

LaMonica: And we’ll reiterate that big point we made before. Like everything in investing, this decision has lots of different considerations. No investor will make the right decision all the time. But we, of course, advocate for investors to be informed. So at least you’re going into each decision fully aware of the trade-offs you’re making.

Jayamanne: A good way to end a short and sharp episode, Mark.

LaMonica: Exactly. So thank you guys very much. We really appreciate it.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)